Natural Gas Pipelines in Crisis

Ken Lay had only joined Enron in June 1984. It was not then known as Enron; the company that Lay took over as chairman and CEO was called Houston Natural Gas (HNG). Lay had assumed the helm at a difficult transition time for the natural gas pipeline industry. Long-standing players, such as HNG, were finding that the industry business model was rapidly changing. Prior to the mid-1980s, natural gas producers sold gas to pipeline owners under long-term contracts. In order to induce producers to commit their gas, pipeline owners customarily provided long-term deals with floor prices and a commitment to “take or pay” for gas, i.e., take a minimum volume of gas at a stipulated price or pay the cash equivalent of having taken the specified gas amount.

Two things happened in the 1980s to destabilize this model. The first concerned the value of newly produced natural gas; prices had fallen to rock-bottom levels, below $2 per million BTUs. The second was a regulatory change. No longer would pipeline operators be able to lock out producers who didn’t commit to ship through their lines. Instead, gas producers were now able to sell directly to end users and require pipelines to ship their volumes for a simple transport tariff.

These changes rocked the gas pipeline industry. Newly developed gas started finding its way directly to end users at the low spot market price. Major carriers increasingly found themselves burdened with gas purchased earlier at higher prices under take-or-pay contracts. Pipeline company financial conditions deteriorated. Debt ratings were downgraded. The carriers labored to work their way out from under disadvantageous contracts. HNG was no exception.

Ken Lay thought he knew how things would play out. His assessment was that natural gas market deregulation would continue to progress; from this, he concluded that future profitability would become a function of scale—that is, the biggest pipeline companies with the most extensive networks would become low-cost providers and would end up dominating a market of natural gas production sold largely at spot prices and moved via low-cost logistics.

As if on cue, the gas pipeline industry began to consolidate. Again, HNG was no exception. In April 1985, a call came from Omaha-based InterNorth suggesting a merger. InterNorth was approximately three times the size of HNG. However, its senior management was aging, its board was divided and both were uncertain about how to cope with the deregulated market. A corporate raider, Irwin Jacobs, was stalking the company. InterNorth needed a deal.

Immediately prior to the merger talks, HNG stock was trading at $45 a share. In just eleven days, Lay was able to extract both a $70 per HNG share price (a 56 percent control premium) and a commitment that he would move up to CEO after a couple of years. The InterNorth/HNG merger closed within the year, and the new entity was christened Enron in 1986.

Unfortunately, the merger did little to alleviate the pipeline company’s immediate economic straits. Profitability was miserable. The natural gas glut seemed to produce ever-lower prices. Enron had to face this deteriorating environment with more than $1 billion in take-or-pay contract liabilities. Enron reported a $79 million loss for 1985, its first year of operation. Attachment 2 details Enron’s financial performance for 1985–86. Although Enron reported net profits of $556 million for 1986, the bulk of that reflected recoveries of past income taxes. Enron’s financial condition was more accurately reflected by the following: earnings before interest and taxes (EBIT), $230 million; interest expense: $421 million.

Enron was now heavily debt-laden, the product of InterNorth’s having used debt to fund the premium price for HNG’s stock. To some extent, this leveraging up of the company had been intentional. Irwin Jacobs’ group was being paid $350 million to hand over its InterNorth stake and go away. InterNorth thus reckoned that a heavy debt burden would act as shark repellant for future raiders; however, high debt levels also hamstrung the newly merged entity. Ken Lay found that his firm’s bank loans contained covenants requiring quarterly interest expense to be covered 1.2 times by EBIT; failure to do so would mean an event of default. Enron would be especially exposed in such case, as the firm also had more than $1 billion of commercial paper outstanding. These unsecured short-term promissory notes had to be rolled over continuously. A hiccup on bank loan covenants could spark a full-fledged financial crisis should it lead commercial paper buyers to flee from Enron’s paper.

In January 1987, Moody’s Investors Service downgraded the company’s long-term rating to below investment grade, i.e., to junk status.

This perilous financial condition meant that Ken Lay spent much of 1986 focused on maintaining liquidity and avoiding the default triggers in Enron’s bank loans. Lay froze senior executive pay and sold some pipeline assets. Enron stayed afloat, but the company was barely scraping by.

In fact, a good portion of the company’s razor-thin margin for error was being contributed by a little-known and understood entity, EOT. InterNorth had created the subsidiary back in 1984. Trading oil commodities was a relatively new business at that time. InterNorth chose to enter the business by hiring an established trader, Louis Borget. InterNorth lured him away from Gulf States Oil and Refining, where Borget had set up a similar unit three years earlier. The package to induce Borget to move included bonuses tied to the profits produced by the trading operation.

EOT immediately began to report profits. In 1985, when the merged InterNorth/HNG lost $79 million, EOT made $10 million. In 1986, when Enron couldn’t cover interest expense with operating earnings, EOT reported profits of $28 million.

Ken Lay still wasn’t sure what to do to fix Enron’s financial problems. He believed that long term, deregulation would reward his company. For the near term, Enron seemed bogged down in a bad business environment of low prices, intense competition, and the burdens of high debt. One thing he did know was that EOT’s contribution was helping the company cope in the short run while it waited for the longer run to bring improved conditions.

Lay had another, more political problem closer to home. The board of InterNorth had rebelled against his predecessor, Sam Segnar, concluding that he had caved in to HNG’s demands during the merger negotiations. Segnar had ended up paying with his corporate head. Lay replaced him but soon faced bitter resistance from former InterNorth directors on a series of secondary but highly symbolic issues: the appointment of Enron’s public accountant and the relocation of Enron’s headquarters to Houston. The issues eventually were resolved, with Lay getting his way on the relocation. Lay had also begun to replace former InterNorth directors with selections more supportive of his leadership. Still, at the outset of 1987, Ken Lay was a CEO under the microscope, facing a board that was divided and in some cases personally bitter toward him.

None of this was lost on Ken Lay as he skimmed over Internal Audit’s memo yet another time.

Considering the Options

Lay’s mind quickly focused on shaping an outcome for the meeting.

What do I do to resolve this issue? I’d better walk into this meeting with some idea of the answer we want at the end.

What really matters here? What issues take priority over others? I have to give preference to the financial condition of our company. This means that EOT’s profit-generating capability needs to be preserved. Moreover, a financial scandal right now could be devastating. Not only might EOT’s profit contributions be affected, but Enron’s past financial results might have to be restated. Accounting restatements are yellow flags, signs that something major is amiss inside a company. It wouldn’t be long before Enron’s equity analysts and lenders get wind of unreported bank accounts, and dubious transactions. They’d assume the worst and wonder what else they didn’t know. The result could be a major crisis of confidence leading to a liquidity crisis for Enron.

Borget and Mastroeni have undoubtedly broken some rules. That’s not a total surprise coming from traders and their culture. We have to find some means to limit abuses while leaving EOT’s risk-taking culture intact.

What exactly are the allegations of wrong doing here? It seems that Borget and Mastroeni either received or thought they’d received signals from Houston to manage the timing of EOT’s reported profits. They responded by doing some of what others in their industry also do—twinned trades that give another party profits in one period to be offset by profits returned in the subsequent period. Such trades are not illegal. They altered quarterly results, but that’s not uncommon: Everybody “manages earnings” one way or another. The worst that can be said is that they executed these trades in a fashion that was less than aboveboard. Clearly, they must have assumed that not everyone in Houston was on board with managing earnings. Why else would they have not reported the new bank accounts? And what’s this about company money going into Mastroeni’s personal account? Whatever the reason, and I’m sure they’ll have one, that’s got to stop.

What to do about it all? How best to keep the big picture in mind but still send a message that excess won’t be tolerated?

With this, Ken Lay picked up a pen and began to outline a set of options. He began by listing categories of possible remedial actions:

• Immediate issue management
• Personnel discipline
• Organizational reform
• Transactional rules
• Process reform
• Organizational oversight

He then expanded each bullet point with possible options to consider:

• Immediate issue management
  • Define the transgressions associated with EOT bank accounts, trades, and the mingling of corporate money with personal accounts, and the mitigating circumstances.
  • Ensure that Enron’s financial condition is a major factor shaping any resolution of the incident.
  • Determine the “materiality” of accounting issues and the need for any restatement of public financial reports.
• Personnel discipline: options
  • Terminate Borget or Mastroeni or both.
  • Terminate Harding or Sulentic, or both.
  • Discipline some or all of the above in terms of future compensation, responsibilities, and title.
• Possible organizational reforms
  • Revise Houston’s oversight of EOT, either changing out current management and/or intensifying oversight in terms of stewardship reviews and/or oversight of controls.
  • Embed new management at EOT:
    • New trading personnel loyal to Houston management, charged to learn EOT’s business model.
    • New financial management loyal to Houston charged to ensure that controls are sound and rules are respected.
    • A financial controls advisor assigned to EOT for the indefinite future.
• Transactional rules
  • Have Internal Audit recommend new/clarified rules for authorizing and reporting bank accounts, trades, and unit financial results.
  • Have the chief accounting officer and/or Arthur Andersen opine on the acceptability of twinned trades done solely for the purpose of managing earnings; consider whether such trades might have other economic rationales.
• Process reform
  • Reconsider established EOT trading limits and Enron’s process for obtaining exceptions; ensure that limits are proportionate to unit profit objectives
• Organizational oversight
  • Decide whether EOT merits a full-time Internal Audit presence; determine also the frequency and timing of audits and the role of Arthur Andersen as external auditor.
  • Review who should be EOT’s legal counsel and whether that presence should be in Houston or Valhalla.

Well, I clearly have a range of options available. Possibly I can blend a couple of different actions to not upset the apple cart while still making it clear to EOT that there are boundaries.

It flitted through Lay’s mind that the meeting’s outcome would go some distance toward setting the tone on financial control for the newly merged company:

There have been whispers in Houston that EOT is not respecting its oil-trading limits. The division’s open position is not supposed to exceed eight million barrels; if losses exceed $4 million, the open position is to be liquidated. Some of Enron’s Houston-based traders are questioning how EOT could generate the profits it was reporting without breaching these boundaries. After all, trading limits contain the magnitude of gains as well as losses. Still, nothing hard has surfaced. Perhaps this is only professional jealousy at work.

Whatever I decide, it will have to be smoothly executed. Enron is in no position to absorb public scandal. This will have to be handled carefully.

It also occurred to Lay that this episode could contain an opportunity. Sometimes, rule breaches are expressions of pressures that need to be resolved; under such pressures, managers sometimes choose the path of least resistance. Was EOT one of these cases? If so, was there a way Lay could use EOT to deliver a message that might reverberate positively throughout the struggling pipeline business?

Lay packed up his notes without making a firm decision on a course of action. He found himself leaning toward correcting the abuses without firing anybody. However, he would reserve judgment on the severity of corrective actions until he heard the full story. Lay also reflected that the oil-trading business was something of a mystery. It was relatively new and not a heritage HNG business; profits seemed to be closely tied to the quality of the individuals doing the trading. In 1986, Borget himself had told the Enron Board that oil trading “as done by professionals in the industry today, using the sophisticated tools available, can generate substantial earnings with virtually no fixed investment and relatively low risk.”¹

Lay resolved to listen carefully to what emerged between the lines at the next day’s meeting—especially to the vibes regarding how EOT generated its profits. Would there be anything more to the auditors’ allegations than what he had already seen in writing and heard from Harding and Sulentic? If so, Lay might have to adjust his plan of action right there at the meeting.

The Meeting with Internal Audit

The meeting convened with Borget and Mastroeni present, along with Enron’s general counsel Rich Kinder, as well as Harding and Sulentic. David Woytek and John Beard represented Internal Audit. Lay opened the meeting, calling on EOT president Lou Borget to address Internal Audit’s concerns.

Borget and Mastroeni laid out the following facts. EOT had been highly profitable in 1986. As this became known, company managers requested that they find a way to shift some profits into 1987. They were told to do this by “whatever legitimate business practice we could.” As a result, EOT resorted to matched, or twinned, trades that would net out over the period 1986–87. Borget observed that such trades were commonly used by other trading companies. Mastroeni stated that EOT had identified three firms interested in boosting their 1986 profits: Isla Petroleum, Southwest Oil and Commodities, and Petropol Energy. EOT then entered into trades with those three entities, selling oil at prices that delivered profits to them during December 1986; the deal was for EOT to buy back oil and recoup equal gains during the first part of 1987. Mastroeni explained that they opened the Eastern Savings Bank account as a place to hold cash proceeds from the 1986 sales. However, because this account was in Enron’s name, Mastroeni stated that he had moved money to his personal account to avoid attracting attention and complicating Enron’s year-end statements. Their intention was to return all funds to Enron in 1987.

Sulentic then added that it was all a misunderstanding, that Borget and Mastroeni believed that they were acting in Enron’s best interests. He added: “I say we accept that mistakes were made, do what needs to be done to correct them, and move on to a profitable 1987.”²

Ken Lay then spoke, making it clear that he disapproved of the methods EOT had used to accomplish its goals. He asked whether anyone else at the meeting had anything to add.

David Woytek spoke up, pointing out that the bank statements EOT had brought to the meeting had been altered. Transactions showing funds transfer into and out of the accounts had been removed. Woytek had the statements provided by the Eastern Savings Bank to document the point.

Mastroeni then explained that the deleted transactions referred to a disputed bonus paid to a trader. The individual in question had been fired near the end of 1985. He had retained a lawyer and threatened to sue the company if his anticipated year-end bonus was not paid. After some discussion, a close-out settlement of $250,000 had been agreed upon. Woytek asked Mastroeni why, if that were so, there was any need to alter the bank records. Mastroeni replied that the incident had nothing to do with the transactions under discussion at this meeting, so they simply took them out of the bank statements to avoid confusing the issues.

Lay listened to the conversation as it surged back and forth. What he had just heard amounted to new information; Borget and Mastroeni had brought doctored bank records to the meeting.

They had made a decision not “to confuse” the issues, in the process attempting to prevent some transactions from coming under scrutiny.

It was getting close to the moment when Lay would need to end the discussion and focus the meeting on what actions should be taken. Lay had now heard Borget/Mastroeni’s stories explaining the opening of the unreported bank account, the origins of the funds transfer into the account and the outflow of money to Mastroeni’s account. How much could he take those stories at face value? And how should this new information—that EOT’s managers had altered bank records—influence the perspectives and options he had mulled over the night before?

Author’s Note

This case relies principally on the accounts of the Valhalla financial control issues provided in The Smartest Guys in the Room (pp. 15–19) and Conspiracy of Fools (pp. 15–19). Both books treat the episode in detail and with minor discrepancies provide accounts that are consistent as to the facts.

Each book offers some details not provided by the other. For example, The Smartest Guys in the Room provides details of the trading limits in existence at EOT, the financial condition and bank covenants of Enron at that time, and the fact that David Woytek sent Ken Lay a memo describing the EOT twinned trades as creating “fictitious losses.” Conspiracy of Fools provides a detailed account of the meeting of EOT’s Borget and Mastroeni, Enron Internal Audit, and Enron management. This work also confirms that Lay attended that meeting and gave explicit instructions as to what remedial actions were to be taken.

The Smartest Guys in the Room (p. 18) identifies Steve Sulentic and John Harding as Borget’s Houston-based nominal superiors. That work quotes “internal documents, court testimony and notes detailing these events” in describing how the two executives articulated a rationale for Borget to “move some profits from 1986 into 1987 through legitimate transactions.” Sulentic’s defense of the traders’ actions as a “misunderstanding” appears in Conspiracy of Fools (p. 18).

Parts of the case are created for purposes of surfacing the issues and options facing Ken Lay. Lay’s thoughts on the night before the meeting, which appear between quotation marks and in italics, have been crafted for these purposes. They do not represent material found in any published source. This applies also to the list of options he outlines while sitting in his office. The portrayal is, however, consistent with (1) the fact that he received a memo from David Woytek on the possible irregularities and (2) the actions taken by Lay at the end of and right after the meeting. It is also apparent from the content of the memo forwarded by David Woytek that Lay had heard at least a preliminary version of the “twinned trade to move accounting profits” story that Harding and Sulentic presented at the meeting. Lay’s options list has obviously been expanded beyond the actions he actually endorsed in order to provide students with a full range of choices to consider.

Attachment 1, Beard’s memo to Woytek, is a Historical Recreation (HRC) intended to summarize the facts known to the auditors prior to the meeting with Borget and Mastroeni. However, it is factually based, being grounded in not only the general accounts provided in the sources but also in: (1) the fact that Woytek did provide a memo to Lay and other senior managers, (2) published comments from Beard’s notes, and (3) a published quote from Woytek’s memo describing the twinned trades as creating “fictitious losses.”

Attachment 2 is drawn from Enron’s restated public financial filings.